Two top asset managers are reading the smoke signals from British American Tobacco — Reinet’s biggest investment — very differently. Shaun le Roux of PSG Fund Managers believes BAT’s strong track record probably led to investor complacency.
"It is unlikely that many analysts spent enough time considering whether the dynamics of the tobacco industry suggested that historic performance was sustainable – and, in particular, if the share’s rating appropriately factored in the range of possible future outcomes," he says.
Le Roux argues that the multi-decade bull market in global bonds supports demand for bond-like equities or "bond proxies". This means that companies with growing cash flows and healthy dividends were attractive alternatives to bonds. "When bond yields are low, p:es for bond proxies are high," says Le Roux. "BAT traded at more than 20 times earnings in mid-2016, when the US 10-year bond yield plunged to its lowest levels in more than a century."
Le Roux also argues that large tobacco companies have been able to raise prices by more than enough to compensate for the ongoing decline in the volume of cigarettes sold.
"In fact, while the number of smokers has kept declining in most markets (particularly in developed economies), revenues have continued to rise — the ultimate demonstration of pricing power."
So, while BAT is expecting volume declines of 3.5%, it is expecting to raise prices by more than 5.5%.
While regulations and new, healthier products have pressured BAT’s prospects, Le Roux says that company-specific problems have also contributed to BAT’s fall. In particular, he flags the high levels of debt from BAT’s overpriced £42bn buy-out of the balance of US tobacco group Reynolds in 2017.
"With the benefit of hindsight, the price paid was excessive, as it came within months of the peak in valuations for bond proxies," he says. "The timing was also unfortunate, given significant subsequent challenges in the US [around cigarette regulations]." He still reckons BAT is a cheap share to buy, relative to its history.
Of course, BAT’s trajectory could go one of many ways, depending on the new regulations, new-generation products (NGPs) and whether the tobacco company can keep its prices high.
Le Roux believes the next 10 years will, in all likelihood, be very different to the past decade. "The key question is: does the current share price for BAT adequately account for this?"
Allan Gray portfolio manager Ruan Stander believes investors can’t ignore BAT’s track record of compounding earnings despite various regulatory changes. Stander also points to evidence that BAT’s investments into NGPs are bearing fruit.
There are high levels of debt from the £42bn buy-out of the balance of US tobacco group Reynolds
— What it means
Stander suggests three scenarios.
First, assuming BAT’s portfolio of NGPs helps it to sustain its 17-year track record – and sentiment towards tobacco stocks remains subdued — an investor today would earn 20% a year growth (growth of 12% plus a dividend yield of 7.8%).
In the second scenario the BAT share price would start two rise, pricing in its track record. Stander says this would result in a higher return, assuming a re-rating to a 5% dividend yield, and a return of 32% a year.
The third scenario is grim.
In this version, the Food & Drug Administration would ban menthol cigarettes and BAT would not retain any menthol-smoking customers.
In that event, Stander believes, BAT growth would only keep up with inflation over the next four years. "At the current price this still results in a good outcome with a total return of 14% a year [6% growth plus a 7.8% dividend yield]," he says.
Put another way, if you have the stomach for BAT’s roller-coaster ride, you’ll probably still earn a decent reward.
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